Friday, January 9, 2015

On the Verge of Another Euro Crisis?

To Canadian political economist Daniel Drache, Europe feels like it could be on the verge of a crisis. Yesterday's violent killings at the Charlie Hebdo newspaper offices in Paris did nothing to change that feeling.

"I think there's lots of turmoil ahead," said Drache, who I called to talk about something called crisis theory. "And when you move to highly ideologized mentalities, then all sorts of shit can happen."

When I had arranged the interview the day before, the attack in Paris hadn't yet happened. Our subject was going to be the rise of a radical left party in Greece, Syriza, that the research group Oxford Economics says is heading for a "decisive victory" in the country's snap election now only 17 days away.

As I wrote last month, the Greek election was almost an accident after Prime Minister Antonis Samaras played chicken with the Greek parliament and lost. Now the establishment coalition, carefully patched together by way of financial support from the European Union, has fallen apart.

There are growing signs that Syriza and its stridently leftist leader Alexis Tsipras could sweep to power in Greece, changing the entire political landscape in Europe. Suddenly the term Grexit, coined nearly three years ago as a shorthand for Greece's departure from the Eurozone, is back in the business headlines.

Turning on the rich

Tsipras has affirmed his commitment to the euro, but not at the expense of continued austerity that is causing suffering among his millions of supporters. Now in an interview splashed on the front page of Wednesday's Financial Times, Syriza says it will begin a "crackdown" on the country's elite, the wealthy oligarchs who, among other things, control Greece's media.

"The oligarchs are high on our agenda," George Stathakis, Syriza's economic spokesman, told the paper. "They will be a priority for action."

According to the Financial Times, a move against the Greek establishment will be "welcomed by international lenders." But some of the planks in the Syriza platform may not be so appealing, especially if they spread to other parts of Europe. Tsipras has pledged to renegotiate the country's bailout agreement with Europe, tossing out austerity, increasing the minimum wage, and delaying the sale of government assets. And he wants to write off Greece's debt.

If the rich countries of Europe stick to their guns, there is only one way that can lead. To Grexit. And thus the crisis.While no one knows for sure, there are serious worries that a departure of one country from the euro currency zone (for which there are no legal provisions) could lead to something worse. With weeks to go before the Greek election, already global markets are quaking.Interest rates on bonds in Greece and southern Europe are shooting up. Rates in North America, Germany and Switzerland are plunging as the global rich look for safer places to put their cash. Fears about the future of Europe are the other reason, in addition to plunging oil prices, that the world's stock markets have turned volatile.

Most analysts seem to think that when it comes right down to it, Europe will figure out a way to bail out Greece to avoid the risk of a destabilizing crisis. Effectively, if Tsipras wins the election and Europe concedes to his demands, a crisis created by the Greek electorate will have forced Europeans to solve what has been an intractable problem. They will transfer wealth from the rich of Europe to the poor of Greece.

The crisis solution

And according to Fernand Braudel, founder of the Annales School in France, Drache explains, that is what crisis theory is all about.

"When institutions fail to adapt or change, then new policies and practices become possible in the crisis," says Drache. But he says moments of crisis create changes that can't be undone. "It's a door opener and a door closer. You can't go back."

The trouble with crisis as a tool for solving problems is that one crisis can lead to another. Thus, the worry that other European voters will demand the same concessions that Greece gets. Voters in other countries may be outraged, because as we have seen in the past, crisis is not just a tool that can be used by the left.

Right-wing populism has risen across the continent. Anti-immigration movements have emerged in Germany and other parts of Europe, like Italy and Portugal, that will only be stoked by the shootings of Charlie Hebdo editorial staff. Political and economic systems shaped by crisis do not always end well.

"It's a wild roller-coaster ride," says Drache of a system that depends on crisis for change. "And it might go off the tracks."

It's sure is a "wild roller-coaster ride" but my advice to investors is to ignore all this talk about "Grexit" and worry more about the long-term effects of European deflation.

In fact, one of the world's best distressed debt investors, Avenue Capital's Marc Lasry, was on CNBC Thursday stating he bought Greek bonds in his personal account and is worried that Europe could be looking at a Japan-style deflationary era:

Lasry's Avenue Capital is continuing to buy credit-side debt at a discount in Europe. Over the last three or four years, the amount of debt that European banks have sold has increased by 100 percent, he said in a "Squawk Box" interview.

"The way that the banks were able to sell this debt is, they keep on buying sovereign debt, and then through that they make their profits, and then each year they end up using those profits to offset losses on that. And that's sort of of what happened in Japan over a 10 year period," said Lasry, who specializes in distressed debt investments.

The way for Europe to avoid a deflationary period is to clock 4 to 5 percent GDP growth, he said.

"You're not having that. The reason everybody focuses on that is because GDP growth in Europe today is sort of, negative one, flat, up one. It's really not moving that much," he said.

The chairman and CEO of Avenue Capital said his firm is playing the credit side of the European debt market because the pressure is still on the banks to deleverage. "This is sort of a five year process, so for us it's going to be the gift that keeps on giving," he said.

Lasry is personally invested in Greek debt, but Avenue Capital does not buy sovereign bonds, he said.

Europe is still in an investing phase because there is $2.5 trillion of debt, he said. "The supply side in Europe is still so great relative to the demand side in Europe," he added.

Lasry is right, Europe is on the verge of a prolonged deflationary era. As far as his personal bet on Greek bonds, I also think this was a smart move. The latest poll numbers suggest Syriza's lead is waning and it will have a tough time forming a minority government (click on image below):

More importantly, even if Syriza wins and manages to form a minority government, as I explained in my comment on the myth of Greek democracy, you have to take the rhetoric out of Greece with a shaker of salt:

To really understand Greece, you have to understand that Greek politicians are blatant liars and corrupt to the bone. It's not just Tsipras. Successive governments from the Left and Right kept increasing the public sector to cement their political base and now that the country is bankrupt, they still can't cut the public sector beast because they fear political repercussions.

Economists will argue that Greece should exit the eurozone, reintroduce the drachma to devalue their way back to economic health. The problem with that logic is that all this will do is introduce rampant hyper inflation and nobody in their right mind will ever lend to Greece again knowing their debt profile will keep getting worse.

And as I've written back in 2012, it's time to look beyond Grexit because the cost of a Greek exit would be crippling not only for Europe but for the rest of the world. All this talk of "containing contagion" is pure fantasy. If Greece exits the eurozone, others will follow and it's game over for this fragile union.

But as critical as I am of Greek politicians, I'm equally if not more critical of German politicians who foolishly thought they were immune to southern Europe's plight and warned the ECB not to go ahead with quantitative easing.

Importantly, the ECB is so far behind the deflation curve that I fear no matter what it does in the coming weeks, it's already too late, the game is over as eurozone deflation becomes more entrenched wreaking havoc on periphery and core economies.

The eurozone has let it happen. Europe's authorities have so mismanaged monetary and fiscal strategy that the whole currency bloc has tipped into deflation.

The drop in the eurozone's headline price index to -0.2pc in December scarcely captures the significance of what is happening. Deflationary forces have been gaining a grip on all the crisis states of the South for 18 months.

A chorus of economists began warning two years ago that the region was sailing close to the wind by letting inflation drift ever lower, leaving itself one shock away from a loss of policy traction. That shock is now hitting in successive waves: the Russia crisis; China's over-investment glut; and now the collapse of oil prices.

Textbook theory suggests that a halving of energy costs should be cause for celebration, a tax cut for consumers. It is very different calculus when inflation is already zero, bond yields are plummeting to 14th century lows across the world, and market psychology is becoming "unhinged" - to use central banking vernacular.

“Normally, any central bank would prefer to look through a positive supply shock," said Peter Praet, the European Central Bank's chief economist. "But we may not have that luxury at present. Shocks can change: in certain circumstances supply shocks can morph into demand shocks via second-round effects."

Mr Praet said families and firms are already adapting pre-emptively to the new order, describing what amounts to a classic deflation trap. "There is a risk of a real economic vicious cycle: less investment, which in turn reduces potential growth, the future becomes even grimmer and investment is reduced even further," he told Börsen-Zeitung.

Mr Praet warned that an "underemployment equilibrium" is setting in, invoking the term used by Keynes in the 1930s. He exhorted "all the authorities", including governments, to step up to their responsibilities and take "urgent action". This is a man who knows that monetary union is in deep crisis.

His boss, Mario Draghi, has been bending every sinew for a long time to head off this awful moment. He went to Berlin as far back as November 2013 to plead for understanding from Germany's economic elites, warning even then that radical measures were needed to secure a “safety margin against deflationary risks”. He feared that the downward slide was pushing EMU crisis countries into a deeper rut as they tried to claw back competitiveness. "Real debt burdens rise,” he said.

Mr Draghi did not invoke Irving Fisher's classic text published in 1933 - Debt-Deflation Theory of Great Depressions - but his message was the same. Falling prices are not benign in highly-leveraged economies.There comes a point when the sailing ship does not right itself by the normal swing of the cycle. It tips too far and capsizes. Try to right it then. The Japanese are still trying 15 years later.

There have been incessant promises of ECB stimulus since that speech in Berlin but little has been done, despite Mr Draghi's valiant efforts. The ECB's balance sheet has contracted further due to "passive tightening", falling by €143bn to €2.15 trillion.

The optimal moment for quantitative easing has passed. It is late in the day, even if the ECB council plucks up the courage this month to force through full-blown QE against guerrilla resistance from the Bundesbank. Yields on 10-year German Bunds have already dropped to a historic low of 0.46pc. Finland is down to 0.54pc, Holland to 0.57pc and France to 0.73. Even Spain has fallen to 1.63pc.

Little can be done by compressing yields yet further, and the ECB is prohibited by treaty law from carrying out more radical action that injects money directly into the veins of the economy. Most likely it will be another fudge, an overly complex formula that avoids any real sharing of risk. Hedge funds may pocket a profit. But it will not create many jobs in Naples.

Without such jobs, Italy's political system is going to blow up soon. Its unemployment rate has just reached a modern-era high of 13.4pc, with youth unemployment hitting a record 43.9pc. The Mezzogiorno is sliding from depression towards social collapse. The Bourbons made a better fist of it.

By cruel contrast, Germany generated 27,000 fresh jobs in December. Unemployment has fallen to a 23-year low of 5pc. Things have never been so good since reunification. There could hardly be clearer evidence that monetary union is unworkable.

The victim states of southern Europe have retrenched heroically, yet deflation effects are overwhelming them. Their debt trajectories are still spiralling up due to the mechanical effect of sticky interest costs on a base of catatonic nominal GDP.

Spain's inflation rate has fallen to -1.1pc, a curse oddly welcomed by the pre-modern Partido Popular as proof that the country's "internal devaluation" within EMU is gaining traction. It certainly is, but the final outcome may not be what they think.

For Italy it is slow torture. Contractionary policies have already pushed the debt ratio from 116pc to 133pc of GDP in three years. Each one percentage point fall in Italian inflation forces the country to increase the primary surplus by 1.4pc of GDP to meet EMU rules, according to the Bruegel think-tank in Brussels. Yet to act on this imperative is to thrust the economy further into a self-reinforcing downward slide.

Optimists think the eurozone has touched bottom. Simon Ward, from Henderson Global Investors, says the forward-looking money supply figures are flashing recovery. His key gauge of narrow M1 - six-month annualised growth - surged to 9.9pc in November. Let us hope that this is the harbinger of reflation, though one wonders what M1 money data still tell us in a mad world of zero rates and zero inflation, where there is no opportunity cost for leaving money idle in M1 cash accounts.

The counter view is that something odd is happening in the global economy. China's factory gate deflation has dropped to -2.7pc, a sign of massive spare capacity. The country's fixed investment reached $7.24 trillion in the first 11 months of 2014, more than in Europe and North America combined. The scale is vast: the deflationary effects are galactic.

Behind it is an excess of capital as the world's savings rate hits a record 26pc of GDP, starving the real economy of demand. One culprit is the $12 trillion accumulation of foreign reserves by central banks. Another is the deformed structure of globalisation, which favours the owners of capital and concentrates of wealth. Add the demographic tipping point across the Pacific Rim and central Europe, and you have a portrait of worldwide "secular stagnation".

The eurozone is least able to respond because it is a dysfunctional construct. There is little point blaming those now in office. The Telegraph has argued since Maastricht that a currency union of disparate cultures with no EMU treasury or political authority to guide it would end in paralysis, with feedback loops entrenching divisions over time.

Mr Draghi issued his own cri de coeur in Helsinki six weeks ago, laying out the "minimum requirements for monetary union". His prescription amounts to an EU superstate, with economic sovereignty to be "exercised jointly".

His plea is Utopian. There is no popular groundswell anywhere for such a vaulting leap forward, and it would imply a technocrat dictatorship beyond democratic control if ever attempted. The northern creditor states have in any case spent the past four years methodically preventing any durable pooling of risk or any step towards fiscal union.

In airing such thoughts, Mr Draghi is really telling us that he no longer thinks EMU can work. Nobody can fault him for lack of effort.

While job growth has been strong, Evans, who's among the most dovish Fed members, said policymakers need to pay attention to the lack of inflation. Prices needs to rise to the Fed's target of 2 percent before he would feel better about the possibility of increasing rates.

Evans pointed to the 5 cent drop in average hourly earnings in the December jobs report—pulling the annualized gain down to 1.7 percent—as "somewhat indicative of the low inflation pressures that we've been seeing." Wages need to rise for the Fed's inflation target to be met, he added."It's one of the dilemmas we're facing. And that's why I'm in favor of being patient on raising interest rates," he continued. "We shouldn't be raising rates before 2016."

Evans said he's hopeful that inflation will pick up. "I'd like to have more confidence that we're going to get to 2 percent by 2016. ... 2017 seems like the minimal allowable. To get there, I think we need more accommodation."

"I don't want to get to a situation like Europe is in," he added—referring to the euro zone moving into deflation. "I want to make sure to get U.S. inflation up to our objective. If it moves down, that's a challenge."

When I covered the Fed's December meeting, I paid close attention to the discussion on inflation. Evans confirms my thinking, the Fed is paying much closer attention to global weakness and how it's impacting domestic inflation expectations.

In this strongly deflationary environment, the consensus forecast anticipates that central banks in the US, UK, Canada, Australia, Brazil and Mexico will all raise their policy rates by 25 to 75 basis points. Barring a quick and sharp reversal in crude oil prices, such rate hikes could prove a serious policy mistake.

It will be interesting to see how this all plays out going into the end of the month. Everyone is worried about Grexit but I think the bigger worry is the euro deflation crisis and long-term stagnation in Europe.

In the meantime, please go back to read my Outlook 2015 to understand why even though it will be a rough and tumble year, there is plenty of liquidity to drive risk assets much higher. I still see a possible melt-up in stocks led by tech and biotech, but there will be plenty of volatility along the way to record highs.

Below, Avenue Capital's Marc Lasry discusses his personal bet on Greek bonds and why Europe could be looking at a Japan-style deflationary environment for the next five years. Also, Chicago Fed President Charles Evans discusses why he'd be patient on raising near zero interest rates and would not make a move before 2016.

Lastly, everybody knows that leaving the euro isn't a "real option" for Greece, says Andreas Koutras, director at InTouch Capital Markets Ltd. He talks from Athens with Guy Johnson and Francine Lacqua on Bloomberg Television's "The Pulse." Excellent interview, well worth taking the time to listen to his comments.

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